In a study on "Incentives and foreign direct investment"(1) released today, UNCTAD advocates that the international community should deal with incentives that distort flows of foreign direct investment (FDI), as it has begun to do so successfully with subsidies that distort trade. A number of immediate measures that could be considered include reviews of national incentive programmes and their effectiveness; negotiating conditional incentive-limitation clauses in bilateral investment and double taxation treaties; regional undertakings to limit the levels of investment incentives packages; and assisting the multilateral process by holding international hearings to find ways of improving reporting, assessment methods and policy approaches, and to uncourage governmental pledges to reduce the level of incentives. In all these efforts, the dynamic effects of incentives, as well as the particular needs and constraints of developing countries, in particular those of the least developed countries, need to be taken into account.

The study provides a comprehensive analysis of the facts, theory and effects of incentives for FDI. It shows that international competition for FDI with fiscal, financial and other incentives is pervasive, and it is even more intense now that it was some ten years ago. Countries have deliberately changed their FDI regimes in light of actions taken by neigbouring countries.

The incentives competition is fierce

The study´s survey of FDI incentives programmes in over 100 countries from all regions shows that the overall number and range of incentives available for TNCs, and the number of countries that offer incentives, have increased considerably since the mid-1980s. Incentives are less often used now to attract FDI flows in general than in the past; rather, they tend to be aimed towards achieving specific purposes. In fact, countries very often offer a number of incentives linked to different objectives, thus further multiplying the number of incentives programmes available to TNCs. As a general rule, developed countries tend to make use more of financial incentives than fiscal ones. However, this pattern is reversed in developing countries, presumably because these countries lack the resources needed to provide financial incentives. Overall, fiscal incentives continue to be the most widely used type of FDI incentive, but, there are significant country and regional variations with respect to the numbers and types of incentives used and their specific purposes. Competition with incentives is not only strong among countries, but also among subnational authorities within states. This is so regardless of whether the countries involved are large or small, rich or poor, developed or developing. At the same time, the general pattern is now not to differentiate, in principle, between domestic and foreign-controlled firms, either in the design or in the implementation of incentives programmes, although significant exceptions exist in which TNCs receive incentives that are not available to domestic enterprises.

Not only are there more and more countries offering a greater variety of incentives to attract and retain FDI flows in general, or to keep their own firms from going abroad, but, as countries are orienting their development and industrial strategies more towards exports, technology intensive industries and higher value-added activities, they are also using more incentives to attract FDI that can contribute to these objectives. As incentives involve substantial amounts of resources and constitutes a trend that is likely to continue, the study emphasizes that it is increasingly important for policy-makers to know more about what incentives are offered by whom and where, in order to evaluate the overall effects of incentives on the global competition for FDI. Unfortunately, one of the main problems encountered with surveys of FDI incentives is the lack of transparency in incentives practice, particularly in the face of the widespread use of ad hoc incentives for major FDI projects.

Incentives can serve a purpose but are costly and can be distortive

The study notes that incentives are more readily accepted in practice than in theory. Whether their benefits exceed their costs, and under what conditions, is a matter of ongoing debate. In theory, incentives can be justified to cover the wedge between the social and private rates of return for FDI undertakings that create positive spillovers (which could arise from FDI-related activities such as transfer of technology, research and development, export activity, training and backward linkages), or, in a dynamic sense, to deal with market failure, and to advance development objectives. However, incentives also have the potential to introduce economic distortions (especially when they are more than marginal) that are analogous to restrictions on trade, and they involve financial and administrative public costs.

The study observes that it is not in the public interest that the cost of incentives granted exceeds the value of the benefits to the public. Otherwise put: the costs should not be greater than the value of the wedge between private and social returns. In practice, however, the calculation of the wedge is complex and problematic; and even when this can be done, the implementation and administration of a calibrated incentives programme is often very difficult.

Moreover, when governments compete to attract FDI, there will be a tendency to overbid in the sense that every bidder may offer more than the wedge. The effects can be both distorting and inequitable because the cost of incentives are ultimately borne by the public and, hence, represent transfers from the local community to the ultimate owner of a foreign investment. In such competition for FDI, the study observes, it is the poorer countries that are relatively disadvantaged.

Icing on the cake

Competition with incentives is strong despite of the fact that a review of the empirical evidence suggests that incentives play a relative minor role in the locational decisions of TNCs relative to other locational advantages, such as market size and growth, production costs, skills levels, political and economic stability and the regulatory framework. However, the impact of incentives is not neglegible. In particular, when all other factors are equal, incentives can induce foreign investors towards making a particular locational decision by sweetening the overall package of benefits, and hence tilt the balance in investor´s locational choices.

With respect to different types of incentives, fiscal incentives generally have some influence on the locational choices of foreign investors, although the movement away from tax holidays in some countries might suggest that the long-term standard tax rate may be more important in influencing FDI flows than short-term fiscal incentives. Fiscal incentives are particularly favoured by export-oriented investors, whereas for projects oriented towards the domestic market, the preferred incentive is domestic market preferences. On the other hand, financial incentives (in particular grants) appear ato be an important factor in TNC choice of location within a country, and have also been preferred to fiscal incentives in these circumstances. But, in general, fiscal and financial incentives seem to run pari pasu in terms of FDI preferences. Among FDI incentives packages, those geared to promoting exports have proven to be most effective.

The experience with incentive packages suggests that, to be effective, the design of incentive programmes aimed at attracting FDI with specific characteristics not only involves careful targeting of those elements that are desirable, but, in addition, policy coordination at various levels of government is necessary to ensure that the incentives do not cause undesirable side effects. There is often a conflict between the goals that governments want to achieve, the incentives systems through which these goals can be achieved and the capacity of the institutions charged with implementing the incentives systems. At the same time, there is often a trade-off between incentives that are targeted to achieve specific policy goals and more general investment incentives. The more targeted an incentive, the greater its impact -- but also the greater the chance that it leads to biases and distortions that impose economic costs on the economy.

Where to go?

No general discipline exists at the multilateral or regional levels to deal with incentives that affect FDI flows and the locational decisions of TNCs, although some limited intergovernmental commitments exist. Containing excesses in competition with incentives requires national as well as international approaches at bilateral, regional and multilateral levels, all of which can be pursued simultaneously. UNCTAD´s suggested programme of action involves the following:

National initiatives. Governments could undertake national incentive reviews to determine, among other things, the complete array of FDI incentive instruments -- including discretionary incentives -- at all levels of government; and to assess whether any of these incentives are redundant or can be eliminated or a ceiling placed on them; what have been the benefits and costs of these incentives for the local economy; and whether a proper balance is being maintained between investment incentives and other promotional activities.

Bilateral initiatives. Noting that some countries have used bilateral investment treaties to curtail the use of performance requirements, the study suggests that it may be possible to negotiate a conditional incentive-limitation clause in bilateral investment or double taxation agreements that would only become operative if a specified number or set of countries adopted the clause.

Regional initiatives. Efforts at the regional level to curtail excessive incentives could involve, among other things, agreeing on overall ceilings on investment incentives packages; on criteria to phase out the most distorting incentives; and on prior approval of incentives programmes by the competent regional organization.

Multilateral initiatives. Multilateral efforts are in their infancy and need to be expanded. To assist this process, UNCTAD´s study proposes that an International Group of Eminent Persons could hold hearings on FDI incentives, with the participation of the private sector as well as national and international institutions. Based on the experiences with the effectiveness of incentives the Group could explore ways and means of (a) improving transparency regarding FDI incentives; (b) further clarifying and documenting the costs and benefits of FDI incentives; (c) identifying a limited number of particularly distortive incentives, with a view towards dealing with them first; (d) elaborating a check list of points that governments should take into account in their incentive policies. The group could conclude its work with a "challenge" round of pledges by countries to reduce the level of incentives by some fixed amount over a time period. A demonstration that such a pledge might be feasible could enhance the willingness of governments to seek a multilateral agreement on FDI incentives.

Just as the international community has begun to deal successfully with subsidies that distort trade, it many be possible, step by step, to make similar progress towards dealing with incentives that distort international investment flows -- the study concludes.